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Financial Institutions, Instruments and Markets
Instructor's Resource Manual
Christopher Viney and Peter Phillips
An introduction to interest rate determination and forecasting
Learning objective 1: Describe at a macroeconomic level how the liquidity effect, the income
effect and the inflation effect influence the determination of interest rates
In forming a view on the future direction of interest rates, it is necessary to recognise that
changes in monetary policy settings are likely to affect the state of the economy, which in
turn affects interest rates generally.
Within the macroeconomic context, these progressive changes are referred to as the liquidity
effect, the income effect and the inflation effect on interest rates.
The liquidity effect derives from monetary-policy-induced changes to in interest rates such as
an increase in interest rates due to a reduction in liquidity in financial system.
• As interest rates rise, economic activity will slow and incomes fall. This will cause interest
rates to begin to ease or fall. This is the income effect.
The income effect will reduce upward pressures on prices as the economy slows and there is
likely to be a reduction in the rate of inflation, thus causing interest rates to fall further (the